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An elaborate definition of ROI
Return on Investment (ROI) is one of the most imperative financial metrics used to evaluate the probability of earning profits from a particular investment. Fundamentally, ROI is a ratio used to compare the gain/loss generated by an investment relative to the incurred cost. Furthermore, ROI can also be used as an effective indicator to compare the returns from different investments.
Here it is also notable that even though ROI is basically a ratio, it is usually expressed in terms of percentage. By calculating the ROI, investors and analysts can ascertain the attractiveness of various opportunities for investment to rank them in a certain order. An essential advantage of using ROI as a measure is that it is incredibly simple to understand and calculate. Moreover, ROI is a universally accepted measure for the assessment of profitability.
Merits of calculating ROI
From the viewpoint of financial analysis, there are various benefits associated with the calculation of Return on Investment. The key benefits of calculating Return on Investment as a significant metric are listed below.
It can be used as an effective and quick measure to analyze the prospects of investment in terms of their profitability. Hence, ROI can play a crucial role in investment decisions.
With the calculation of ROI, the potential returns relative to various investment opportunities can be compared in real-time. Besides, on the basis of ROI, investors can also explore worthwhile investment opportunities.
Within a business organization, ROI can also be used to quantify the benefits offered by enhanced investments across different operations or departments. For instance, companies can use metrics such as marketing ROI, employee training ROI, and ROI across other functionalities to assess the performance of their investments.
Even for people who do not have expert knowledge of corporate finances, ROI is a simple measure to comprehend and they can draw comparisons between investments in a worthwhile way.
Implications of positive ROI and negative ROI
A positive return on investment signifies that the net returns from an investment are in excess of the costs incurred. On the flip side, a negative ROI implies that the cost of investment exceeds the overall returns.
However, one major disadvantage of using ROI as a metric for gauging the profitability prospects of an investment is that it does not account for the period for which an investment is held. Moreover, as a financial measure, ROI does not account for risk. Needless to say, most investments are subject to some risks which directly impact the returns. Also, ROI is susceptible to exaggeration and manipulation.
The next section sheds light on the different formulas that can be applied for the calculation of ROI for different purposes of financial analysis.
Explanation of formulas for calculating ROI
1. Simple calculation of ROI
|Net Return on investment X 100
|Cost of investment
2. Calculation of ROI using investment values (for any investment)
|((FVI - IVI) + (Profit/Dividend - Costs/Brokerage)) X 100
Where: FVI = Final Value of Investment
IVI = Initial Value of Investment
3. Calculation of Shareholding ROI
|((FVI - IVI) + (Profit/Dividend - Costs/Brokerage)) X 100
For the calculation of shareholding ROI, it is essential to first calculate the capital gains, dividend gains, and costs/commission/brokerage.
The formulas for calculating these metrics are listed below
|FVI X 100
|Dividend X 100
|Cost (inclusive of commission or brokerage)=
|Cost X 100
4. Calculation of Annualized ROI
As mentioned above, the basic ROI calculations do not account for the time period for which an investment is held. However, by calculating annualized ROI, this limitation can be dealt with. The metric of annualized ROI can help analysts and investors determine the average ROI generated per year during the entire course of time for which an investment is held.For instance, if an investment yields an overall Return on Investment of 40 percent after 7 years, by calculating the annualized ROI, the average rate of return for each year can be calculated. The formula for calculating the annualized ROI is given below.
|Annualized ROI (%)=
|[ (1+ ROI)1/n - 1] x 100
Where n = number of years and the overall ROI can be calculated from the formula given in the above sections.
Alternatives to ROI as a financial metric
As explained above, although ROI is a simple and standardized metric for evaluating the profitability of an investment, it also has some limitations as a metric. Having said that, are other alternatives to the ROI that can be used for calculating and evaluating returns.
Primarily, the Internal Rate of Return (IRR) can be a more detailed and credible measure of returns. To explain, IRR is an overall measure of the cash flows received in the course of the entire span of an investment and is expressed as a percentage. As an effective metric, IRR also takes into consideration the timing corresponding to cash flows and this consideration is essential for industries like venture capital.
Furthermore, Return on Equity is another alternative to Return on Investment. To define, Return on Equity is the ratio between the net income earned on an investment and shareholders’ equity. ROE is one of the most essential and credible financial ratios for assessing the profitability of a business, project, or investment.
Lastly, Return on Assets (ROA) is another effective and reliable measure that can be used as an alternative to Return on Investment for gauging an investment’s profitability. To elucidate, Return on Assets is a measure of the ability to drive profitability from the assets linked to an investment. It can also be defined as a ratio between the total net income generated and the total assets with respect to an investment or enterprise.
An alternative to Return on Investment can be considered subject to the type and purpose of financial analysis being conducted.
To encapsulate, Return on Investment is an important financial ratio that is a standard measure of net gain or net loss on an investment. In the simplest terms, ROI can be understood as the ratio between the net income generated on an investment and the cost of investment. However, if ROI needs to be calculated taking into consideration the time period for which an investment is held, analysts or investors need to calculate the annualized ROI.